TED spread is one of those semi-obscure finance concepts that is getting press all of the sudden because of our current economic situation. Two years ago, only bankers and economists cared about the TED spread, but now I run into TED spread updates out in the blogosphere with increasing frequency and the business press seems to print a story every time it budges by a bip or two.

The TED spread is the difference between interest on loans that banks give each other and interest on US Treasuries. It is called the TED spread because originally it was defined as the spread (or difference) between T-bill rates and rates on Eurodollar futures contracts (eurodollar futures being one of many ways that banks lend money to each other). Actually, the ED part is typically represented by the London Interbank Offered Rate (or LIBOR) which is simply a kind of average on the rate of interest that banks are charging each other. 3-month T-bill and LIBOR rates are used, which means that the indicator is closely tied to expectations of short term economic performance.

So why is TED spread important? Well, it is a measure of the overall perception of risk in the market place. Put another way, if the TED spread is high, banks don't trust each other very much. If banks don't trust each other, it is typically because banks are failing. Banks usually fail as a result of an economy in trouble.

You see, interest rates increase as risk increases, because lenders want to be compensated more if they are less sure that they will be paid back. It is essentially a gamble. Safe bets are very likely to pay off, but they don't usually turn into big wins. One in a million odds don't pay off 999,999 out of 1,000,000 times, but when they do, the winner wins big.

So the difference between the risk of lending money to a bank and the risk of lending money to the government (which is what you are doing when you buy a T-bill) leads to different interest rates associated with these activities. The risk of T-bills is generally assumed to be close to 0, but the interest rate on T-bills is often not. This makes the T-bill rate a good baseline that we can use to exclude other factors that enter into interest rates (like the time value of money and inflation).

Historically, the TED spread has been 0.10% to 0.50% (an average of about 0.30%) until recently, when it has shot up as high as 3.0% due to the subprime crisis. Note that because all interbank lending basically shut down during the (current) peak of the crisis, the few offers that were made had more influence on this number than they would under normal circumstances.

Note that if the TED spread ever goes significantly negative (say a couple of percent for example), it might be a good time to invest in non-perishable food items and ammunition, because this would mean that the market thinks it is more likely more likely that good ole Uncle Sam will default on its obligations than it is for Citibank or Bank of America to do so. This would generally be assumed to be a very bad thing indeed.

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